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Tuesday, March 21, 2006

Synthetic corporate bonds

India has many restrictions against debt flows, but is fairly open on equity flows. In particular, for registered FIIs, there are no limits in terms of buying or selling securities such as Infosys common stock and securities such as futures and options on Infosys common stock. Suppose there are foreign investors who seek to buy Indian corporate debt but are presently prohibited from doing so. Can a clever design overcome the situation?

As a general principle, we know that financial innovation renders capital controls porous. The Indian situation is a relatively unique logic puzzle where the foreign investor is given access to a liquid spot market, a liquid stock futures market, and a relatively illiquid stock options market. Can these raw materials be combined to produce payoffs that are similar to a corporate bond?

I feel that a key aspect of the situation is the dramatic extent to which the firms of India have become highly deleveraged. Equity financing now dominates. Many firms, such as Infosys, have gone down to zero debt. I feel there are some cool things that can be done using the common stock of zero-debt companies; that a key ingredient to toss into the pot is the assumption that the firm has no debt.

In short, the rules of the game are: you have access to spot and futures for a zero-debt company, and at a pinch, you have access to options too. How do you produce a synthetic corporate bond?

I can think of one interesting set of moves, to produce a low volatility cashflow while abiding by these rules:

Setup a SPV in a tax haven.

Buy $100 million of Infosys shares in India. These generate a stream of dividends in the future.

Issue a senior claim on the assets - which is "an Infosys bond". The residual (subordinated / junior) claim is then a "leveraged Infosys equity".

Just to fix ideas, the senior claim promises to pay cash of Rs.10 per year for five years and, in the end, pay Rs.100. So it looks like a five-year maturity, 10% coupon, corporate bond issued by Infosys. Every year, the SPV takes stock of the cash and shares available with it. The SPV first pays Rs.10 to the senior investors. If there is no cash in hand (i.e. the Infosys dividend dropped to 0), it sells shares to obtain Rs.10. If there is any cash in hand at the end of these steps, this is sent to the subordinated investors.

At the end of five years, the position is liquidated. The first Rs.100 obtained are paid out to the senior investors. After that, if there is residual cash, it is paid out to the subordinated investors.

The senior claim is akin to a "fixed income" instrument issued by Infosys. A Japanese insurance company or pension fund, that likes to buy corporate bonds, might like to buy these "Infosys corporate bonds". The subordinated claim - how about a name like "supercharged equity"? - will be bought by the usual risk-loving characters such as the hedge funds.

If India's capital controls are binding, and there is an unmet desire for corporate bonds on Infosys amongst overseas investors, then this set of trades can add value.

The senior claims are not corporate bonds in one key respect: the treatment of bankruptcy. When a corporate bond fails to pay a coupon, this is a default event, and the bondholder gets the company. In contrast, the senior investors of the SPV don't have recourse to a bankruptcy process where they takeover Infosys in the event of bankruptcy. While I respect this difference, I still feel that the senior claim does have risk/return characteristics that are a lot like a corporate bond, particularly since India doesn't have much by way of a bankruptcy process.

Another fly in this ointment is that the structure works best as long as Infosys preserves their zero-leverage structure of liabilities. If (say) next year, Infosys chooses to issue debt, then that muddies the waters. The investors in the senior claim on the SPV would be unhappy because now there is some other debt which is more senior than them, at the mother source. There could be a provision in the contracting - a "debt covenant"? - that the entire structure will unwind, at prices driven by formulas agreed-upon as of today, in the event that in the future, Infosys issues debt. In other words, if Infosys issues debt in the future, then the senior and the subordinated paper are both put back to the originator where they are extinguished, and the originator sells off his Infosys shareholding in India.

I don't know how to think clearly about tax efficiency. Does that dimension break the design?

Another path to synthetic corporate bonds is through stock options. Suppose the assets of the firm are V and equity (E) is a call option on V. The foreign investor has access to trading the call and trading the call on call. In the special case where the firm has no debt, E=V and the call options on E (which are accessible) are call options on V. It looks like one can work through put-call parity and construct a synthetic corporate bond.

The trouble with that route is that India doesn't allow investment in the riskless. In addition, the maximal maturity, liquidity and market efficiency of the stock options market is not that attractive. So maybe some years out, this will become possible. The senior/subordinated structure is feasible today.

7 comments:

Nice. I have one question though ..While I respect this difference, I still feel that the senior claim does have risk/return characteristics that are a lot like a corporate bond, particularly since India doesn't have much by way of a bankruptcy process.

How would you incorporate the credit risk from the SPV into the pricing. Wont it be much higher than the credit risk from Infosys ?

Sorry, I was not clear enough. The "credit risk" that matters is that of the underlying company (Infosys). E.g. if Infosys issued corporate bonds, and if it was not able to service them, then the rules that kick in should be that the bondholders get the company.

"Failure" of the SPV is not an issue if care is taken in setting it up. The SPV is just a placeholder for a contract. Cash comes into the SPV, and the SPV pays out cash to senior and then subordinated claims based on well-defined rules. The SPV is bankruptcy remote from the entities involved in setting it up. So I don't think there is credit risk of trouble-at-SPV. Difficulties at the SPV are just operational risk, not credit risk.

What you mention is fairly similar to a synthetic collateralized debt obligation (CDO) that I see a lot of at work. As opposed to a regular CDO that has underlying bonds as its reference entity the structure you propose has infosys equities as the underlier.What about trying to diversify the different underlying reference equities to get some portfolio benefit to the stream of dividends that you receive (so have infosys, tata, biocon, hero honda, etc). I don't know how this is done in India, but it is quite common in the US (although again for bonds).

I agree with you that corporate bond market is not deep or liquid enough in India. To have full fledged capital market to rival the rest of the world, I think it is imperative that we develop some framework to enable that. Leverage can tremendously benefit most Indian companies.

Yes, it is like a CDO in some ways. Yes, you could buy (say) a Nifty portfolio, and then break the cashflows into senior/subordinated and thus get "corporate bond" versus "supercharged equity" out of that also. It depends on what the customers want.

I was after the most narrow point: If India tries to block investments into bonds issued by Infosys, is it possible for financial innovation to create synthetic corporate bonds, using the raw materials that are available?

A person who wants to remain anonymous said to me: "Indian shares are not transferrable nor is a lien on them permitted. So whoever sets up the SPV, probably an FII license holder, their credit will flow through the SPV. The SPV cannot directly hold the shares since it probably wont get the benefit of a FII license from SEBI. "

If India does try to block investment of bonds by infosys, perhaps it is possible to trade bonds synthetically in the OTC default swap market. Of course, all such transactions would probably have to be cash settled, since access to these bonds would be restricted. So I guess perhaps it would not be that easy to trade these then, right?

What about if Infosys should choose to issue these bonds outside India via a separate legal sub, in say the UK, or the US? Sort of like an ADR. Do you know if there are restrictions on that?

I agree that investor in senior claim of infosys bond will have same risk/return features as if bond originally issued by Infosys.But this structure does not reduce cost of capital of Infosys as the shares issued to SPV are still equity shares on Infosys balance sheet and have high cost of equity.In order to bring infosys's cost of capital to cost of bond level, I have a workaround (might be wrong also). If SPV issues the junior claim to infosys itself, then net net infosys is liable to pay just the fixed component to senior claim as whatever the SPV distributes to junior claim, comes back to infosys only. So on these $100 shares issued to SPV, it is enough if infy earns what is just required to pay fixed component.

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